International bonds are a debt instrument. They are issued by international agencies, governments and companies for borrowing foreign currency for a specified period of time. The issuer pays interest to the creditor and makes repayment of capital. There are different types of such bonds. The procedure of issue is very specific. All these need some explanation here.
Types of International Bonds
1. Foreign Bonds and Euro Bonds
International bonds are classified as foreign bonds and Euro bonds. There is a difference between the two, primarily on four counts. First, in the case of foreign bond, the issuer selects a foreign financial market where the bonds are issued in the currency of that very country. If an Indian company issues bond in New York and the bond is denominated in a currency other than the currency of the country where the bonds are issued. If the Indian company’s bond is denominated in US dollar, the bonds will be used in any country other than the USA. Then only it will be called Euro bond. Secondly, foreign bonds are underwritten normally by the underwriters of the country where they are issued. But the Euro bonds are underwritten by the underwriters of multi-nationality. Thirdly, the maturity of a foreign bond is determined keeping in mind the investors of a particular country where it is issued. On the other hand, the Euro bonds are tailored to the needs of the multinational investors. In the beginning, the Euro bond market was dominated by individuals who had generally a choice for shorter maturity, but now the institutional investors dominate the scenes who do not seek Euro bond maturity necessarily to march their liabilities. The result is that the maturity of Eurobonds is diverse. In England, Euro bonds with maturity between 8 and 12 years are known as intermediate Euro bonds. Fourthly, foreign bonds are normally subjected to governmental regulations in the country where they are issued. For example in the case of Yankee bonds (the bonds issued in the USA), the regulatory thrust lies on disclosures. In some of the European countries, the thrust lies on the resource allocation and on monetary control. Samurai bonds (bonds issued in Japan) involved minimum credit rating requirements prior to 1996. But the Euro bonds are free from the rules and regulations of the country where they are issued. The reason is that the currency of denomination is not the currency of that country and so it does not have a direct impact on the balance of payments.
2. Straight Bonds
The straight bonds are the traditional type of bonds. In this case, interest rate is fixed. The interest rate is known as coupon rate. It is fixed with reference to rates on treasury bonds for comparable maturity. The credit standing of the borrower is also taken into consideration for fixing the coupon rate.
Straight bonds are of many varieties.
- First, there is bullet redemption bond where the repayment of principal is made at the end of the maturity and not in installments every year.
- Second, there is rising coupon bond where coupon rate rises over time. The benefit is that the borrower has to paid small amount of interest payment during early years of debt.
- Third, there are zero coupon bonds. It carries no interest payment. But since there is no interest payment, it is issued at discount. It is the discount that compensates for the loss of interest faced by the creditors.
- Fourth in case of bond with currency options, the investor has the right to receive payments in a currency other than the currency of the issue.
- Fifth, bull and bear bonds are indexed to some specific benchmark and are issued in two trenches. The bull bonds are those where the amount of redemption rises with a rise in the indeed. The bear bonds are those where the amount of redemption falls with a fall in the index.
- Finally, debt warrant bonds have a call warrant attached with them. (Warrants are zero coupon bonds.) The creditors have the right to purchase another bond at a given price.
3. Floating Rate Notes
Bonds, which do not carry fixed rate of interest, are known as floating rate notes (FRNs). Such bonds were issued for the first time in Italy during 1970 and they have become common in recent times. The interest rate is quoted as a premium or discount to a reference rate which is invariably LIBOR. The interest rate is revised periodically, say, at every three month or every six month period, depending upon the period to which the interest rate is referenced to. For example, if the interest rate is referenced to one month LIBOR, it would be revised every month.
FRNs are available in different forms.
- In the case of perpetual FRNs, the principal amount is never repaid. This means they are like equity shares. They were popular during mid 1980s, but when the investors began to ask for higher rate of interest, many issuers could not afford paying higher rates of interest. Such bonds lost their popularity.
- Secondly, there are minimax FRNs where minimum and maximum rates are mentioned. The minimum rate is beneficial for the investors, while the maximum rate is beneficial for the issuer. If LIBOR rises beyond the maximum rate, it is only the maximum rate that is payable. Similarly, the minimum rate is payable even if LIBOR falls below the minimum.
- The third form is the drop lock FRN where the investor has the right to convert the FRN into a straight bond. Sometimes the conversion is automatic if the reference rate drops below a mentioned floor rate.
- Fourthly, there is flop flop FRN. It was first issued by the World Bank. In this case, the investor has the option of converting FRN into a three month note with a flat three month yield. Again the note cab is converted into a perpetual note after the completion of the three month period.
- Fifthly, there are mismatch FRNs. In this case, the interest rate is fixed monthly, but interest is paid six monthly. In such a situation, the investor may go for arbitrage on account of difference in interest rates. Such FRNs are also known as rolling rate FRNs.
- Sixthly, one of the recent innovations has come in form of hybrid fixed rate reverse floating rate notes. They were used in Deutsche mark segment of the market in 1990. These instruments paid a high fixed interest rate for a couple of years. The investors received the difference between LIBOR and even a higher fixed interest rate. They reaped profits with the lowering of LIBOR.
4. Convertible Bonds
International bonds are also convertible bonds meaning that these variant are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights. In other cases, there is automatic convertibility into a specified number of shares.
Convertible bonds command a comparatively high market value because of the convertibility privilege. The value is the sum of the naked value existing in the absence of conversion and the conversion value. The conversion price per share is computed by dividing the bonds face value by the conversion factor, where the conversion factor represents the number of shares into which each bond could be exchanged. Suppose, a bond having a face value of $ 1000 can be exchanged for 15 shares the conversion price will be equal to; 1000/15 = $ 66.66
Thus, if the market price of share is less than $ 60, bondholders will not be interested in converting the bond into equity share. This is so because for a bond of $ 1000, a creditor will get 15 shares or $ 900 only. But if the market price of share is $80, the investors will convert the bond into equity shares and sell the equity shares in the market. This way each bond for $ 1000 will fetch $ 1200. In other words, the price of convertible bonds depends upon the price of the equity shares.
In the case of bonds with detachable warrants, the warrant can be detached from the bond and cab be traded independently. The issuer has a double source of financing. The bonds remain outstanding even if the warrants are exercised.
From the viewpoint of the borrowers, convertible bonds cost less because they have lower coupon. They also help decrease the debt equity after conversion. From the investor’s point of view, convertible bonds represent a better option as the investors get a fixed income in the form of interest prior to conversion. After conversion, they become the owner of the company.
5. Cocktail Bonds
Bonds are often denominated in a mixture of currency. Such bonds are known as cocktail bonds. There are two forms of cocktail bonds – one is denominated in SDRs represent a weighted average of five currencies, while the Euro represents a basket of 11 currencies. The investors purchasing the cocktail bonds get automatically the currency diversification benefits. The foreign exchange risk on account of depreciation of any one currency is offset be appreciation of another currency.
Procedure of Issue
There are different stages involved in the issue of international bonds. Since the issuer – normally a government or a company – does not have a detailed idea about the international financial market, nor it is easy for the issuer to perform several formalities, it approaches a lead manager who advises the issuer on different aspects of the issue. Normally, the lead manager is a commercial bank or an investment bank. The issuer selects a particular lead manager on the reports published by different agencies about the performance of the investment banks I the area of lead managing. The lead manager advises the issuer regarding the main features of the issue, the timing, price, maturity and the size of the issue and bout the buyer’s potential. The lead manager takes help from the co-manager, although the bulk of the work is done by itself.
After getting advice from the lead manager, the issuer prepares the prospectus and other legal documents. In this process, the issuers own accountant, auditors, legal counsel are very important for designing the issue in accordance with the financial need of the company as well as with regulatory provisions existing in the country. Sometimes the advice of the lead manager is also sought in order to make the issue suitable for indicators prevailing in the international financial market. The lead manager charges fee for the advice. The fee is known as management fee. When all this is over, the issuer takes approval from the regulatory authorities. After the approval, it launches the issue.
The second stage begins when the issue is launched. Investors look at the credit rating of the issuer as well as who is underwriting the issue. This is why the lead manager along with co managers helps in the credit rating of the issuer by a well recognized credit rating institution. At the same time, it functions as an underwriter and charges underwriting fee.
The third stage begins after the underwriting process is complete. This stage includes the process of selling the bonds. More often, the lead manager functions as a selling group and for that it charges commission at varying rates.
The investors, on the other end, are individuals. They are institutions, such as investment trust, banks and companies. They often purchase the bond through their buying agents. There are also trustees who are usually a bank appointed by the issuer. Their duty is to protect the interest of the investors, especially in vase of default by the borrower.
Sometimes the lead manager acts as a trustee. Finally, there are listing institutions. They enlist the bonds for secondary marketing. The secondary market for international bonds is mainly an over the counter market, although the bonds are listed with the stock exchanges. It may be noted that the entire procedure of the international bond issue is complete within a specified time span. After the press release of the prospectus, it takes 27 days. The first 12 days are spent on sales campaign which is known as the offering period. On the 12th day, underwriting agreement is signed, which is known as the pricing day. During the following 15 days, bonds are sold and delivered and the necessary payments made.
Documentation requirements for a bonds issue are complex. There are seven documents that are required. The first is the prospectus. It informs about the issuer, its management and about it’s past, present and future operation. It also covers the political and economic make up of the country. The second is the subscription agreement. It comprises denomination, coupon rate, issue price and maturity of the bond, underwriting commitments, details of selling arrangements, closing date and the terms of payment, names of the paying agents and trustees, details of lilting conditions under which agreement cab be terminated, the legal jurisdiction and rules regarding compensation in case of misrepresentations or breach of warranties. The third important document is the trust deed which is an agreement between the issuer and the trustee for an orderly servicing of the bond. The fourth document is the listing agreement that shows listing centers. The fifth document is the paying agency agreement executed between the issuer and the bank that pays the agent for servicing of the bond. The sixth document is the underwriting agreement that brings in confidence among the investors. The last document is a copy of the selling group agreement that tells about the agencies involved in the sale of the bond. All these documents accompany the bond certificate.
Secondary Market Operation
Facilitates do exist for secondary market operation for foreign bonds and Euro bonds. In the case of the former, listing is done on a particular stock exchange in a particular country. But for Euro bonds, many financial centers are involved. This is why transaction takes place in over the counter market. However listing with international stock exchange helps Euro bonds in determination their price, depending upon the performance of the issuer and the demand for the issue. When the price is determined and the issue is ready for sale, the stock exchange helps the deal. Normally, there is spread of one half of one per cent between bid and offer prices. Settlement instructions are routed through the clearing house located in Brussels and Luxembourg, and delivery of bonds is made against payment. Clearing may also take place through book entries.
Sometimes, before the secondary market starts functioning, the particular Euro bond is in great demand. Such trading is known as grey trading, although such cases are rare. For smooth operation of the clearing houses and operation of the secondary market, there is an Association of International Bond Dealers, which was set up under Swiss law as far back as in 1969. It frames rules for smooth operation.
Development of International Bond Market
Foreign bonds emerged on a substantial scale as early as in 1950s. The US dollar was then the strongest currency. In order to obtain US dollar, issuers from different countries issued bonds in the US financial market. These Yankee bonds were very popular. However, with weakening balance of payments, the US Government imposed restrictions on the issue of Yankee bonds in 1960s. The restrictions provided impetus for the emergence of Euro bonds. The first Euro bond was issued by an Italian borrower, Autos trade in 1963. Many other Euro bonds were issued subsequently. But since bank lending dominated the financial scene till early 1980s, sizeable growth in Euro bond market took place only thereafter. The total bond volume increased from US $ 38 billion in 1980 to US $169 billion in 1985 and to US $ 230 billion in 1990 (BIS, 1992).
During 1990s, owing to greater liberalization in the international financial market, which was more apparent in Germany, France and Japan, the size of the bond market grew at a faster rate. By March 1995, the amount involved was over US $ 2210 billion. In 1995, the straight bonds dominated the scene as they accounted for over three fourths of the issue. FRNs accounted for around one – seventh. The rest was accounted for by convertible bonds. Again, it was found that Japanese yen denominated bonds were mainly fixed rate bonds, while floating rate bonds were denominated mainly in A British pound. The Swiss franc denominated bonds were normally the convertible bonds (BIS 1997).
Yet again, around two fifths of the total issues in 1995 were denominated in US dollar, a little less than one fifth in Japanese yen, about one seventh in DM, and the rest of the bonds were denominated in other currencies. In the case of bonds issued by the firms and governments of developing countries, 57 per cent of the issue was represented by US dollar and over one- quarter was denominated in Japanese yen. The share of DM was hardly one- tenth. The value of yen bonds increased during 12990s because may Latin American Brady bonds came to be denominated in yen in view of greater attraction for them among Japanese investors (BIS 1997).
In 1995 the average size of maturity of international bonds was 4.3 years, but subsequently, it rose due to longer term bonds issued by many corporations. Again, after the Mexican crisis of 1994, some of the Latin American governments tried to re establish benchmarks in international financial market and issued international bonds. This resulted in the growth of sovereign bonds during these years.
Credit: Global Financial Markets and Instruments-PU